If you’re shopping for a mortgage, one of your goals is to probably find as low of a rate as possible. An adjustable-rate mortgage (ARM) can be one way to secure a lower rate — at least at first before the rate adjusts.
With a 10/1 adjustable-rate mortgage, you’ll get to lock in your rate for 10 years before the interest rate changes annually. Since ARMs typically start out with lower interest rates than fixed-rate loans, they can be attractive options for homebuyers.
What is a 10/1 ARM loan?
An adjustable-rate mortgage, or ARM, is a home loan with an interest rate that can change over time.
Here’s what the two numbers indicate:
- The first number: The number of years in which your interest rate remains fixed.
- The second number: How often the rate will adjust annually after that fixed period.
For example, with a 10/1 ARM, the rate stays fixed for the first 10 years of the loan. Each year after that, the interest rate can adjust to reflect market rates.
10/1 ARMs are one of the most popular types of ARMs. While they usually come with higher rates than say a 5/1 ARM or a 7/1 ARM, they’re still competitive relative to 30-year fixed-rate loans.
Good to know:
A 10/1 ARM differs from a 10-year mortgage. With the latter, you’ll pay off the mortgage over the course of a decade. But with a 10/1 ARM, you often take on a 15- or 30-year term.
Learn More: What Is a Mortgage Rate and How Do They Work?
How a 10/1 ARM works
ARMs adjust over time, resulting in a lower or higher monthly payment, depending on how rates fluctuate. Your payment changes to ensure that your mortgage is paid off on time.
With a 10/1 ARM, your mortgage rate will begin to change after the fixed-rate period of 10 years.
There are often caps on how much a rate can adjust upward, which might save you from unmanageable monthly payments. Here’s a closer look at how 10/1 ARMs work:
Changing rates
Adjustable rates are determined by an index, which offers a look at what’s going on in the market, and a margin that’s added to the market rate.
Every year after the end of your fixed-rate period, the lender takes a look at current market rates and then adds the margin amount to get your new mortgage rate and payment.
Here’s a quick breakdown of how the index and margin make up your rate:
- Index: This is a collection of different rates on the market and is usually expressed as some type of weighted average. In the past, one of the most common indexes used was the London Interbank Offered Rate (LIBOR). However, LIBOR was phased out and many U.S. lenders now use the Secured Overnight Financing Rate (SOFR). Other indexes that could be used include the Constant Maturity Treasuries (CMT) and the Cost of Funds Index (COFI).
- Margin: You won’t pay the base market rate for your mortgage. Instead, the lender will add an extra percentage to the index to determine your rate. For example, if you have a margin of 3.25% and your rate adjusts based on the SOFR — and the SOFR is at 0.10% — your new mortgage rate would be 3.35%.
Tip:
Ask your lender to find out which index it uses, along with the margin it adds to the index.
Keep Reading: ARM vs. Fixed Mortgage: How to Choose Between Them
Interest rate caps
Even though your home loan rate adjusts each year after the initial 10-year fixed period, there are limits on how high your mortgage rate can go.
Normally, rate caps follow a sequence of a first adjustment, subsequent adjustments, and a lifetime cap. One of the most common cap structures is the 2/2/5 cap. Here’s how the 2/2/5 cap structure works:
- Initial adjustment cap: Your initial adjustment, represented by the first number, is the first time the lender adjusts the rate following the end of the 10-year fixed term. In the case of the 2/2/5 cap, the rate can’t be more than two percentage points higher than your initial mortgage rate, no matter how much interest rates have increased since you got your home loan.
- Subsequent adjustment cap: Each year, there’ll be another adjustment to your rate. The cap for this adjustment is indicated by the second number. With the 2/2/5 cap, every subsequent adjustment made can’t exceed two percentage points over the previous rate.
- Lifetime cap: Finally, the last number in your cap structure represents the total lifetime cap, based on your initial rate. In the 2/2/5 example, the interest rate can never be higher than five percentage points above your first rate.
Loan terms
As you look to get a mortgage, remember that 10/1 ARM loans often have an overall term of 15 or 30 years. So, you’ll enjoy a fixed rate for 10 years, and then, depending on the term, your rate will change annually for the remaining five or 20 years.
For a better sense of what you’d pay each month (in principal and interest only) with a 10/1 ARM vs. a fixed-rate mortgage, let’s run through a quick example:
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